Past Exam Questions: April 2014 Flashcards
Describe the “key man” risks arising from the retirement of a company founder
The risk that the loss of the founder will pose to the ability of the organisation to:
- continue to achieve its strategic objectives
- maintain its profitability
- keep its customers
- avoid an adverse share price impact
- and meet its obligations to customers.
This includes the loss of the founder’s intellectual capital and potential contagion risk from the loss of other members of the management team who might no longer remain loyal to the company.
Outline how “key man” risks can be mitigated
Key man risk is not a risk that can be removed by transferring it to an insurer or another party. It has to be retained and the emphasis should therefore be on taking active steps towards reducing the risk exposure.
The main strategy should be a succession plan, which will set out the actions that the firm is taking in this regard.
For example, it should cover:
- Early identification of the intended successor(s) and “job-sharing” towards the retirement date.
- Capturing the founder’s knowledge and ensuring that all processes in which they are involved are well documented.
- Training programs for other staff members.
- Communicating externally to clients and other stakeholders including moving other staff members into key relationship roles.
- Communicating internally to staff on the issue of succession in order to help set career paths.
- Recruitment activities, if necessary.
- An employment contract with the key man with a notice period and other conditions designed to give the company time to replace the key man.
- For example, keep him on in a non-executive role.
There may be “golden handcuff” bonus arrangements with other important staff members, to avoid a contagion effect.
State the advantages of setting up a group captive insurer to insure the risks of the rest of the group
- Cheaper - may have lower overhead costs.:
- Cheaper – can retain risk and therefore avoid transferring profit to external insurance providers. Similarly it avoids cash swapping which means paying a premium with the almost certainty of having a large portion of it returned as claims.
- May give the group greater control e.g. over which risks (and how much) are retained.
- Access to wholesale insurance / reinsurance markets.
- Increased purchasing power - buying in large volume rather than by company.
- Possible tax advantages.
Comment on the appropriateness of regulation under which there is no distinction between open market and captive insurers
FOR:
- ensures captive insurers are held to the same standards as open market insurers in terms of prudent management and governance.
- no opportunity for regulatory arbitrage.
- may be simpler for the regulator.
AGAINST:
- does not recognise that captives generally take lower overall levels of risk than open market insurers.
- can add to the overhead costs of running a captive insurer.
Describe the main risks that a retail bank will be carrying in its asset-liability management programme
CREDIT RISK
Risk of a counterparty being unable or unwilling to make payments required under an agreement.
INTEREST RATE RISK
The risk of changes to the asset-liability value due to changes in interest rates - i.e. the change in the net present value of assets less liabilities.
Second, optionally risks which arise from products that have an option to take certain actions and are more likely to do so in a rising / falling interest rate environment (e.g. early redeemable loan assets)
CURRENCY RISK
Net exposure to changes in foreign exchange rates. For example the bank might borrow in USD and report in USD and may lend some monies in Euros without hedging the exposure.
LIQUIDITY RISK
The ease with which assets can be converted to cash.
Liquidity risk generally increases as the average term of assets less the average term of deposits increases (called the liquidity gap).
Liquidity is highly subject to systemic (contagion) risk as the willingness of banks to lend to each other in times of financial crisis is materially restricted.
Loan to deposit ratio (LDR)
The ratio of a bank’s nominal loan book to its deposits.
Liquidity Coverage ratio (LCR)
The ratio of a bank’s high quality liquid assets to its 30-day stressed net cash outflows.
Stressed net cash outflows are substantially higher than normal net cash outflows.
Net Stable Funding Ratio (NSFR)
The ratio of a bank’s stable funding to its weighted long-term assets.
Stable funding includes equity, customer deposits and long term wholesale funding.
Long term assets includes all loans with maturities longer than one year, a percentage of loans with less than one year to maturity and a percentage of government and corporate bonds.
Basel III will likely introduce a minimum LCR requirement of 100% and a minimum NSFR requirement of 100%
Outline the steps that banks should undertake to optimise their funding mix, given these upcoming requirements
- The development of a comprehensive funding plan.
- A review of current liabilities ordered by cost to the bank.
- Determination of the cost of every type of funding and its characteristics over the past 5 years.
- Determination of the expected cost and range of costs of every type of funding and its characteristics over the next 5 years.
- Determination of the optimal funding mix based on stable / non-stable split, regulatory impact and value for money.
- A target date to reach the optimal funding mix and a deposits plan to work in reshaping the balance sheet.
2 possible approaches to fitting a distribution to extreme values
BLOCK MAXIMA (RETURN LEVEL) APPROACH
Separate the time series data into evenly-sized blocks. Select the highest observation in each block and fit a generalised extreme value (GEV) distribution function to the data using a maximum likelihood estimator.
PEAKS OVER THRESHOLD APPROACH
Choose a threshold level over which the data are considered to be extreme. Fit a generalised Pareto distribution to all observations minus the threshold (for those observations exceeding the threshold) using a maximum likelihood estimator.
BLOCK MAXIMA (RETURN LEVEL) APPROACH
Why is the block size crucial in fitting extreme values?
- If it is too big, then too much data is discarded.
- If it is too small, then too much non-extreme data will be fitted and the goodness of fit will be unduly weighted towards non-extreme data (and likely under-fit the tail).
Compare using GPD versus GEV when applying Extreme Value Theory
The GPD will typically keep more data and so is often preferred. The choice of the threshold is important for the same reasons that the choice of the block size is important with the block maxima approach.
Both methods assume that the underlying data are independent and identically distributed.
Seasonality, trends and serial correlation in the data will violate this assumption.
State the circumstances under which the shape parameter of both the GPD and GEV density functions would be expected to be nearly the same.
Extreme Value Theory’s asymptotic law states that for long block lengths, the block maxima approach will result in a generalised extreme value function and that for high thresholds the peaks over the thresholds approach will result in a generalised Pareto distribution.
At this point the shape parameters of the fitted GEV and fitted GPD will effectively be the same and their means and variances will be related.
Discuss whether flood data can be used to price rainfall derivatives in a given area.
Flood levels are different from precipitation data and precipitation data is likely to be available.
Flooding can occur from rainfall occurring in a different area, e.g. river systems with different catchment areas and snow melt versus rain.
If they are trying to protect against flooding and only precipitation derivatives are available then the results are likely to be helpful, but the precipitation data should also be collected and analysed.
the flooding data would provide the information regarding the appropriate trigger points for the precipitation weather derivative.
Main risks an international food company would carry during the early years of implementing large business expansion strategies
- Risk of failing to meet the company values.
- Reputational risk negatively impacting the existing business.
- Impact on the group leverage and cash flow of the business expansion.
- Strategic risk of failing to meet the plans and objectives of the business venture, and ultimately failing to produce the budgeted returns on investment.
- Agency risk associated with new employees having different cultures and values.
- Political risk, being the risk of future government interaction.
- Regulatory and tax changes
- Business risks:
- – competition
- – supply
- – demand
- – input price inflation.
- Currency risk